By NEOH SOON KEAN
In the first part of this informative series, I explained why investment is such a mental and emotional ‘game’. Because a majority of investors lack the mental strength and self-confidence to stick to the right investment principle, it is important that an investor develop a framework upon which he can build up his portfolio without being side-tracked by what is happening in the market at any one time.
A plan of action forces one to continue even if the circumstances are most terrifying. So, the first step in becoming a successful investor is to develop a plan which is optimal for your condition.
What are the major components of your investment plan? There are three important steps that you must take. We covered the First Important Step in Part 1 published on July 1. Today, we discuss the Second Important Step that (just like the First Step) consists of 3 sub-steps.
- DETERMINE AN OPTIMAL ASSET ALLOCATION
Asset allocation means how much of your total pool of assets is to be put into shares and how much is to be put into other types of investment. Although in the long run, proper share investment is likely to produce higher return than alternative assets, there are certain disadvantages to shares as investment.
First, in the short term and through improper share selection, the price of a share can fall below its purchase cost. In a later article, I shall explain how one can try to improve one’s ability to select good stocks. But even so, share prices can fall due to unfavourable circumstances: e.g., political upheavals or wars in another part of the world. Some people are discomforted when they are faced with this type of ‘paper’ loss (it is only a ‘paper’ loss because the shares have not yet been sold).
Second, shares can be illiquid. That is, it is slow to turn shares into cash. In truth, more often than not, such illiquidity is psychological rather than real because an investor is often unwilling to sell at a loss or at lower than his perceived ‘fair’ price.
Third, as has been said before, share investment involves a long time-horizon. If your time horizon is short (e.g., you are near retiring), shares are less suitable.
The more highly are you in possession of these three attributes, the smaller should be the percentage of your total assets to be put into shares.
For example, if you have very short time horizon (say, 5 years), and you may need to suddenly convert your investment into cash (e.g., for medical expenses) and are much disturbed by the fall in its value, then you should have a very small percentage of your investment in shares (perhaps close to 0%). For people in this category, they should consider placing the bulk of their investment in safer and/or more liquid investment such as ASM/ASB, FD and EPF.
On the other hand, if you are have longer time horizon (say, 10 years or more) and you do not think you are going to need to convert a large portion of your investment into cash quickly and you are not perturbed by the loss in the value of your share investment, you can afford to have a much higher percentage of your investment in shares. If you are in this category, you can have a very high percentage of your investment in shares; perhaps as high as 75%.
Most people are unlikely to be in these two extremes. For them, an optimal percentage would be somewhere between 25% and 50%. Each of us will have to decide for ourselves what this percentage is.
- SPREAD OUT YOUR INVESTMENT OVER TIME
A very common mistake of inexperienced investors is to put their money into the stock market over a short time or, even worse, all at once. As stated, the stock market is schizophrenic: it can be very high or very low at times. It is very difficult for an average investor to tell whether the market is high or low.
In fact, there had been several occasions when even the Chairman of US Federal Reserve (its central bank) made the wrong judgement about the stock market. Market timing is one of the most difficult arts to perfect. Even Warren Buffet often says that he is not capable of timing the market correctly.
The correct way to deal with the highly uncertain nature of stock market is to invest progressively over a long period of time. This way, one can even out the good times with the bad times. If you are young (hence have a long horizon) and have regular surplus from your income, then you would make the ideal investor. Buying into the stock market regularly over your working life is the ideal way to invest.
If you are not in such a fortunate circumstance or you suddenly come into a large sum of money for investment, it will still be best for you if you invest progressively over a year or two or longer. This same principle applies to the purchase of individual stocks as well. You ought to spread the purchase an individual holding over 10 or 20 tranches.
- DIVERSIFY YOUR INVESTMENT WIDELY Another very common mistake of inexperienced investors is to invest only in a small number of, or even worse, a single share. This is especially common when the stock market is ‘hot’ and ‘stocks du jour’ abound. Just as with market timing, selecting the right stock to invest is not easy.
Despite my long exposure to KLSE, I call myself lucky if I can get 70% of the stocks I choose to perform in the way I have expected. Until today, I still suffer the occasional severe losses on the stocks I purchase for one reason or another. For the average investor, it is best to buy a wide selection of stocks unless one has the ability of Warren Buffet.
Why is it important? Consider the situation that one of the stocks you have chosen turns out to be bad and incurs total loss (not necessarily because of bad management as severe losses can arise from natural disasters or geopolitical events). What if you hold only five stocks? This one single loss would lead to you losing 20% of the total value of your investment – a very tragic situation indeed. But if you have a portfolio of 30 stocks, that loss would only lead to a loss of 3.3% of your total investment – a much more tolerable situation.
So how many stocks should you hold in your portfolio? Statisticians have determined that a portfolio of about 30 stocks would even out much of the good and bad events such that your portfolio would produce a return similar to the overall market. I am sure most readers would jump up at this point and say: “There is no way I can accumulate a portfolio of 30 stocks!”. I agree that for many investors it will not be easy to spread your purchase over 30 stocks even though the size of a board lot has now been brought down to 100.
At a minimum, I would recommend a portfolio of 15 stocks. If you still find this difficult to achieve, 8 would be the lowest number I would suggest at the start and gradually build the number up. Also remember, these stocks have to be chosen form a wide range of industries. It is not diversification if all your, say, 15 stocks are from the property sector because they will be exposed to the same risks. If you have 15 stocks, I would recommend that they be selected from at least 5 different industries.
In Part 3, I shall go into the details of how to select suitable shares for your portfolio. Look out for the start of Part 3 in the July 15 issue.
